Don't Lose the Memory of Panic

Timothy Geithner is the president of Warburg Pincus, a Wall Street private equity firm. Before joining Warburg Pincus, Mr. Geithner served as the 75th secretary of the U.S. Department of the Treasury. He previously served as President and Chief Executive Officer of the Federal Reserve Bank of New York from 2003 to 2009. He began his U.S government career with the Treasury Department in 1988. Mr. Geithner holds a B.A. in government and Asian studies from Dartmouth College and an M.A. in International Economics and East Asian Studies from Johns Hopkins School of Advanced International Studies.

Timothy Geithner: Financial crises that are the most dangerous ones, they follow and they’re caused in effect by a long period of excess confidence where the power of the belief, for example, the house prices won’t fall. That it’s safe to lend a lot of money, take on a lot of risk, because there’s not much risk of recession. And when you lose that memory of panic of the crisis, that creates the seeds in some sense for the vulnerability. And that’s sort of the central cause of financial crisis. Of course, our crisis was caused by lots of other things too, you know. There was some really bad behavior and some – a lot of predatory lending, a lot of abuse, a lot of fraud, a lot of regulatory failure and other things like that. But the most damaging thing was the power of that simple belief that because the world had been relatively stable, it would be stable in the future.

And in a panic it’s sort of the opposite. In a panic darkness overcomes everyone and the natural human instinct to protect yourself results in, runs in a sort of a stampede. And the collective impact of what’s individually rational is what makes, you know, economies vulnerable to collapse when you let panics burn too hot. So in that sense beliefs and confidence are central both to the causes and the solutions. Because the only way to break a panic is to convince people that they have no incentive to run, that it’s safe to stay, safe to lend, safe to spend. In the classic financial crisis in the nineteenth century the way they stopped runs on banks was to stack gold in the window or silver in the window so people could see there was an amount of resources vastly in excess of any likely demands by depositors and that’s what broke panic. So what we try to do is the modern more complicated, more sophisticated counterpart to that in a very different system which is to make the force of the response so powerful, so large relative to the forces of panic that you could break the panic which ultimately we were able to do.

The tragic thing is, you know, we’ve had centuries of experience with financial crises. They happen in very simple financial systems where you just have banks, nothing fancy, no derivatives. They happen in fancy complicated systems. And they’ve happened over time. They happen in systems before deposit insurance and capital requirements and they’ve happened in the presence of those things. The core of the vulnerability is, of course, that banks borrow depositors money, depositors have the right to withdraw that money on demand. And then to use those resources to make loans to businesses or to homeowners to buy a house or to finance a capital investment. Those are longer term loans. They’re not things you can sell or liquidate or recover in a panic. So if people line up to take their deposits out that creates the condition for collapse, because the bank cannot meet all those demands for withdrawals in an instant, because they can’t sell and unload all those investments, those loans, those homes, and recover value to do that.

And that’s what creates the inherent vulnerability to panics. We learned that lesson in the Great Depression as countries have learned it since then. And to protect the economy, the average person – Main Street America – against that risk you have to constrain the risk banks can take, force them to hold a lot of liquid resources capital against deposit against losses. But you also need a very strong fire station so that you can reduce the incentive for people to run, make them more confident that their savings would be safe when things fall apart. These things happen recurrently over time because of the power occasionally of beliefs of that excess confidence. But the reason why that is damaging despite the history of these things is they happen – severe ones happen pretty rarely, you know. Again for the United States it wasn’t since the Great Depression. No living memory of that. And in some ways it’s when you lose the memory of it that you become more vulnerable to it.